Separating deposit-taking from investment banking: new evidence on an old question

Matthieu Chavaz and David Elliott

On 16 June 1933, as the nationwide banking crisis was reaching a new peak, freshly elected US President Franklin D. Roosevelt put his signature at the bottom of a 37-page document: the Glass-Steagall Act. Eight decades later, the debate still rages on: should retail and investment banking be separated, as Glass-Steagall required? In a recent paper, we shed new light on the consequences of this type of regulation by examining the recent UK ‘ring-fencing’ legislation. We show that ring-fencing has an important impact on banking groups’ funding structures, and find that this incentivises banks to rebalance their activities towards retail mortgage lending and away from capital markets, with important knock-on effects for competition and risk-taking across the wider banking system.

How does ring-fencing affect bank behaviour?

Ring-fencing came into effect at the start of 2019. The regulation requires large UK banking groups to separate their core retail banking services from their investment banking activities, in order to protect UK retail banking from shocks originating elsewhere. Unlike Glass-Steagall, ring-fencing allows banking groups to continue to run both retail and investment banks. To do so, however, these groups must house their retail deposit-taking business in a subsidiary (the ‘ring-fenced bank,’ or RFB) that is separate from the entity housing their investment banking operations (the ‘non-ring-fenced bank’, or NRFB) — as illustrated in Figure 1. As we show in the paper, this requirement implies a substantial change in the extent to which different assets across the group are funded by retail deposits. Relative to the funding mix before the reform, the retail funding share of assets that can be placed in the RFB (such as mortgages) increases by around 18 percentage points on average. Meanwhile, the retail funding share of assets housed in the NRFB (mainly wholesale and investment banking) decreases by around 45 percentage points on average.

Figure 1: Stylised balance sheet of a banking group affected by ring-fencing

The left panel illustrates the balance sheet of a fictional banking group before ring-fencing. The right panel shows how the balance sheet might change after ring-fencing. Note that, in reality, most banking groups have a much wider range of assets and liabilities than those illustrated here.

In order to understand how this change affects banks’ behaviour, we use loan-level data for the UK mortgage market and the global syndicated lending market, and analyse the lending behaviour of banking groups over the years between ring-fencing legislation being passed (2013) and implemented (2019). To isolate the impact of ring-fencing from other developments, we compare the behaviour of banking groups who face a large change in funding structure as a result of ring-fencing to those who are unaffected, or for whom the change is more modest. In addition, we compare how the behaviour of the same bank differs between loans that will sit on the balance sheet for several months or years after ring-fencing implementation (and should therefore be affected by the change in funding structure) to loans that mature before 2019 (and are therefore unlikely to be affected by the restructuring). We only aim to estimate the impact of the change in funding structure on bank lending behaviour, and do not analyse other potential impacts of ring-fencing, for example relating to compliance costs.

Our results indicate that ring-fencing encourages UK banks subject to the reform to rebalance their activities towards retail lending and away from capital markets. Specifically, banks whose funding structures are more affected by the reform reduce the interest rates they charge on domestic mortgages, leading to an increase in the quantity of their mortgage lending. Meanwhile, they reduce their provision of syndicated credit lines and underwriting services to large corporates. This rebalancing is consistent with the idea that deposit funding provides certain advantages to banks — for example, because households place a high value on the liquidity of deposits, or because of deposit insurance — and that redirecting these benefits towards consumer lending leads to a reduction in the cost of consumer credit.

When we compare the effects of ring-fencing across different mortgage products, we find that the reduction in interest rates is larger for mortgages with maturities over two years, consistent with the idea that the funding stability of retail deposits allows banks to engage in maturity transformation. In contrast, we find no evidence that the reduction in rates is larger for higher LTV mortgages, despite the fact that the cost of retail deposits is relatively insensitive to the riskiness of the bank.

What are the effects on the wider market?

Ring-fencing requirements only apply to the largest UK banks. These banks hold large market shares in the mortgage market, suggesting the potential for spillover effects on their smaller competitors. Indeed, we find that, by offering cheaper mortgages, large banks more affected by the reform gain market share, leading to an increase in mortgage market concentration. Smaller banks respond by increasing the riskiness of their lending. Specifically, in those products and geographical areas where the large banks grow more, smaller banks tend to reduce the rates on high LTV (>90%) mortgages, and increase the share of these loans in their lending portfolios.

What does this tell us about recent developments in the UK mortgage market?

Two trends in the UK mortgage market that have attracted the attention of policymakers in recent years are falls in interest rates and increases in high-LTV lending by smaller lenders. We can use our results to estimate the role of ring-fencing in contributing to these trends.

Our results suggest that the reduction in the price of large banks’ mortgages caused by ring-fencing can explain around 10% of the overall decline in mortgage spreads observed between 2013 and 2019. In line with the Bank’s December 2019 Financial Stability Report, ring-fencing has therefore contributed to the ‘price war’ in UK mortgages, without being the main driver.

Meanwhile, our estimates indicate that the indirect effect of ring-fencing on small banks can explain around 30% of the increase in high LTV mortgages in small banks’ lending portfolios between 2013 and 2019. Again, therefore, ring-fencing appears to be one of several potential drivers of this development.

What are the broader policy implications?

By redirecting the benefits of deposit funding to retail credit markets, ring-fencing reduces the cost of credit for consumers. The cheaper credit is not concentrated in the higher-risk segment of the mortgage market, limiting financial stability concerns related to rising household indebtedness. The expansion of consumer credit is mirrored by a reduction in lending to large corporates. While the net welfare effects of this rebalancing are uncertain, we find that the reduction in corporate credit is mainly focused on lending to foreign borrowers, who are less likely to be reliant on relationships with UK banks.

Our results also suggest more ambiguous impacts on the retail credit market over the longer term. First, ring-fencing appears to lead to more concentrated markets. The increased market power of large banks could lead to more expensive credit and reduced quality of service over the longer-term; alternatively, increased concentration might simply reflect less efficient banks leaving the market. Second, the increased retail focus by large UK banks could reduce their exposure to international shocks; but by encouraging smaller banks to take more risk, ring-fencing might increase their vulnerability to shocks.

Matthieu Chavaz works in the Bank’s Monetary and Financial Conditions Division and David Elliott works at Imperial College London.

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